3 Critical Ways Credit Scores Can Be Obstacles When Purchasing Real Estate

By Chika

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Last Updated: November 12, 2021

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Real estate is one of the oldest forms of investment. For ages, people have always aspired to acquire landed property to protect their wealth, hedge against inflation, and leave an inheritance for their children. 

However, not everyone is able to achieve this lofty dream. In countries such as the United States, purchasing real estate usually requires huge capital, thus requiring most people to take out loans to finance their real estate purchases. 

While this is a widely available option, it is not always within the reach of everyone. Credit scores play a huge role in determining if you are eligible for a loan and how much you can borrow.

This article shows how credit scores affect you when purchasing real estate. 

 

The Power of Credit Scores

To determine if you have the capability to pay back the loan, lenders examine a lot of areas before they make a mortgage offer and try to get a complete picture of your financial situation. A key piece of information that lenders use to determine your financial capability is your credit score. 

Credit scores are used to determine the level of risk a borrower poses to the lender. Because credit scores are built over long periods, it offers lenders an insight into the financial behavior of a client. 

Credit scores are an important component of real estate investing as it impacts everything from the size of the loan you are eligible for to the interest payments you would be required to pay. It affects the negotiating power an investor has when sourcing for loans. As such, it is important that investors have an idea of their credit score, including how assets and liabilities affect them before venturing into real estate investing. 

 

3 Factors That Affect Your Credit Score

The three major factors which lenders use to determine your credit score are your assets, liabilities, and debt-to-income ratio. When compared to each other, lenders can determine your financial capability appropriately, including how and when you would be able to pay off the loan for your real estate investment. 

 

1. How assets affect your credit score

The word “asset” refers to anything that is useful or holds present or future value. You can list your liquid or illiquid assets in your prequalification form. Liquid assets are those assets that can be converted to cash easily. These include your savings and checking accounts, certificates of deposit, monetary gifts, retirement accounts like 401(k)s and individual retirement arrangements, and portfolios of stocks, bonds, and mutual funds.

Illiquid assets are assets that can’t be converted to cash easily. These include things like your car, business, existing real estate, and any other personal items of value. Lenders place less emphasis on illiquid assets because they cant be converted to cash easily which gives them less reassurance that you can use them to offset your loans. 

The more assets you have over liabilities, the higher your credit score. The higher your credit score, the more ammunition you have to negotiate lower interest rates. This implies that a good credit score would get you a loan at lower costs. The usual cut-off mark for a real estate loan is 752. If your credit score is higher, you would be deemed a top-tier borrower, with comes with the benefit of better rates and more options.

 

2. How liabilities affect your credit score

Liabilities are debts that are owed. They may be revolving or non-revolving. Of the two, lenders pay particular attention to your revolving debt over your non-revolving debt. In mortgage applications, liabilities are car loans, student loans, alimony, credit card debt, and other mortgages. 

 The financial coats of your liabilities determine the amount you would be offered and the interest rate. The amount of liability you have affects your debt-to-income ratio, which invariably determines your eligibility for a mortgage. The higher your debt, the lower the amount of mortgage you qualify for, and the higher your interest rate. 

Revolving liabilities affect mortgage qualification the most. Two of the most significant liabilities that home buyers are faced with are revolving liabilities - Student Loans and Car loans.  Student loan payments make it more difficult to save or invest which reduces your credit score in the long run. For example, missing a student loan payment can lower your credit score. 

Car payments, on the other hand, are high due to having shorter amortization schedules. The Average auto monthly payments are $400 per month. This is equivalent to an $80,000 mortgage.

Liabilities increase your risk, which means lenders would find it less desirable to offer you a mortgage. Even if you have a lot of savings, if your debt exceeds your assets and income, your lender would be worried that you can’t pay. This is because you would not have sufficient mortgage reserves to take care of your mortgage payments. 

 

3. How debt-to-income ratio affects your credit score

Having liabilities doesn’t mean you don’t qualify for a mortgage. Lenders use various means to evaluate your financial situation. One of the most essential tools which lenders use to access your financial situation is the Debt to income ratio. 

Your debt-to-income ratio helps lenders assess your financial character and gauge your ability to pay back a loan. This gives them a comprehensive picture of your financial status and ability to pay the mortgage.

DTI is as vital as your credit score and job stability, if not more so. A good DTI ratio score for real estate or mortgage loans is 36%. A higher debt-to-income ratio could imply either you will have to pay more interest or  may be considered unqualified for a loan. The lower your DTI ratio, the better your chances of obtaining a loan. 

To calculate your debt-to-income ratio, add up all of your monthly debts and divide the sum by your monthly income. Alternatively you can use a DTI calculator. 

 

How to Improve Your Credit Score

The only way of improving your credit score is by reducing your liabilities and increasing your assets. However, the latter part may prove to be difficult considering the fact that you would have to put away extra money which can be used to acquire assets. The simplest way is by paying off your liabilities. Even if you do not acquire assets per se, reducing your liabilities gives the lender the impression that you are financially responsible and would be able to meet up with your payments on your real estate loan. 

There are various ways of reducing your liabilities. These include paying off your credit card debt faster, reducing your expenses, placing a limit on monthly credit card transactions, paying off loans with the highest interest rates first (debt avalanche), and consolidating your debt. The key thing is spending less and saving more.

 

Improve Your Chances

As seen from above, your credit score comes with significant implications on the possibility of investing in and owning real estate. It tells the lender your risk value which is evaluated using your assets, liabilities, and debt to income ratio. A higher credit score enables one to negotiate loans at a lower interest rate.

In addition, you have more options (as regards the choice of real estate) than someone with a low credit score. However, this does not mean that having debts would disqualify you outright. If you have a good debt-to-income ratio, then you stand a chance of getting a loan, but you have to be prepared to pay higher interest rates for low loans.

As such, it is advisable to build up your assets and reduce your debts prior to applying for a loan to finance your purchase of the real estate. This way you can increase your credit score which would make lenders view you as a less risky client to deal with. 

Photo by Sigmund on Unsplash

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